Michael Balkin and Karl Brewer

William Blair Small Cap Growth Fund

by Marla Brill
MFI Publisher

In December 1999, just as the technology and Internet stock bubble was poised to burst, the William Blair Small Cap Growth fund opened its doors to investors. In the first quarter of 2000, co-managers Michael Balkin and Karl Brewer loaded up on stocks of small, high-tech companies with trendy names like Webmethods and Aspect Development.

Looking back, that might sound like a sure route to becoming one of the year’s numerous poster children for battered, IPO-driven small company growth funds. Yet by the end of 2000,  the fund was up 33.7 percent. How did co-managers Michael Balkin and Karl Brewer manage to avoid the flameout that plagued so many of its competitors that year?

“We looked in around in March and saw the wind shifting. We knew the craziness couldn’t last,” says Balkin. “So we sold our more aggressive stocks, and bought some of the ‘old economy’ names people had given up for dead. Because we were so small, we could quickly maneuver into more defensive, dull stuff like consumer goods, business services, and health care.”

The Bold and the Boring

Typical of their purchases at that time was Iron Mountain, which owns and operates records management storage warehouses for businesses. The stock remains one of the fund’s top ten holdings because of its predictable revenues and enduring, if unexciting, business model.

 “Iron Mountain’s business is about as mundane as it gets,” says Balkin. “But if you look around just about any office in the country, you’ll see Iron Mountain storage boxes waiting to go out. And their customers just keep paying those storage bills year after year.”

Stocks like Iron Mountain are a far cry from the hot tech stocks the fund favored at its inception. But their presence shows that Brewer and Balkin have no qualms about mixing old economy stocks with stocks of companies in more experimental, and potentially riskier, lines of business. And, they don’t hesitate to take a more aggressive or conservative investment posture fairly quickly if they feel market conditions warrant it.

While some might call such maneuvering style drift, Brewer and Balkin say it’s simply a component of active management. “We move across different sectors of the small company growth universe, depending on our outlook,” says Brewer. “If we think technology is the place to be, that’s where we’ll go. If we think it’s better to be in more defensive areas, we’ll move there.”

Often, the fund’s holdings straddle the broad spectrum of small cap market risk. Nestled alongside predictable “tortoise” stocks like Iron Mountain are more trendy names such as diagnostic lab services provider Dynacare, the fund’s largest holding. The company is the third largest in the industry, behind Quest Diagnostics and Laboratory Corp. of America. The Toronto-based company’s stock sells at a significant discount to those much larger competitors, and its earnings have consistently beat Wall Street estimates.

Balkin and Brewer first bought Dynacare stock when the company went public at $10 a share in November 2000. When it dropped to $4 a share by March of last year, they decided to buy more. “We knew that the pricing pressure had nothing to do with the company itself. It was a busted IPO situation where supply simply exceeded demand,” says Brewer.  Today, the stock trades at about $15 a share.

The fund’s eclectic small company stock blend has helped the fund produce a total return of 26.7 percent over the one-year period ending January 10, compared with a drop of 3 percent for the average small company growth fund. Today, the fund has a strong presence in defensive areas such as health care and business services companies, such as FirstService Corporation. Brewer says the condominium management company “has a durable business franchise that is growing at a sustainable, predictable rate. Demographics are working in its favor, since more people are moving to the Sun Belt and buying condominiums. And the bottom line is, people will always need someone to clean the pool, cut the grass, and collect assessments.”

Complementing such evergreen business models are more aggressive core positions that the managers may “trade around” for years. One of them, XM Satellite Radio Holdings,  offers subscription satellite radio services for about $10 a month. Although it was one of the fund’s worst performers in the third quarter of last year, it rose sharply in the fourth quarter after a national product rollout and the favorable publicity that accompanied it.  While the stock fell again earlier this year after a Salomon Smith Barney analyst downgraded it from outperform to neutral, it is still up sharply from $5.24 in late September to about $16 a share in mid-January.

Brewer remains optimistic about the company’s long-term prospects, even though he doesn’t expect it to reach profitability for several years. “Ten years from now, most radios will have an AM band, FM band, and a subscription-based XM Band,” he predicts. “This company’s business resembles the model set by the cable television business.” 

Next: A Resurgence For Growth